September 23, 2010
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As prepared for delivery
Distinguished colleagues, ladies and gentlemen. Let me first join Mr. van der Mensbrugghe adding my welcome to all of you and thanking you for coming. I believe events like this—bringing together officials, academics and representatives of civil society for a focused discussion of difficult issues—are one of the most effective ways in which the Fund can contribute to informed decision-making in critical areas of economic policy. And few areas are as important and urgent as reforming the architecture of the financial system.
One key aspect of this task, of course, is reforming aspects of the tax treatment of the financial sector; which is our topic today. Our own thoughts on this issue were set out in the IMF’s report on financial sector taxation that was presented to the G-20 in June this year, and on which you will hear more detail soon. (You will find the report itself, as well as some background material that we are making available for the first time today, in the packs given to you this morning). Indeed, substantial tax innovation has already taken place over the last few months, especially in Europe; and the issue, as we have seen in the last week, is still very much alive. The time, therefore, seemed right to us to bring together leading participants in this debate to take stock of current thinking, measures adopted, and future plans. I am delighted to see such impressive attendance today.
While taxation is our focus today, it is important to remember that any tax measures will be part of the wider financial sector reform. With that in mind, I would like in these opening remarks first to place taxation in that broader context, before offering some thoughts on the potential role of tax measures. Finally, I would like also to reflect briefly on reactions to the IMF’s report for the G-20.
Any analysis of the financial sector reform has to start by assessing what went wrong—while recognizing that, as someone used to say about the French revolution, it is still soon to make a final judgment.
As the Fund already stressed in early 2009 (the Lessons papers), the crisis shared several characteristics with many others – 130 altogether, at the last count – that we have seen since 1970. Asset prices had become overvalued: this time house prices, rather than, as previously, commercial real estate, exchange rate or stock prices. Credit had grown too fast. Loans of marginal quality had become a large share of new lending. And systemic risks, whether through the commonality of overvalued house prices or exchange rates, had increased.
Still, some features were more specific. Most important was that the build-up of systemic risk affected the largest advanced countries, with deep financial systems. Second, the buildup occurred during a period of solid global growth, and price stability lulling many into complacency. This (with few exceptions) confounded, market participants, policy makers, regulators and international financial institutions alike, including ourselves at the IMF. There are lessons in these two features already: firmer surveillance must extend to all countries equally even those considered as posing low risks; and warnings should not be ignored.
There were three other factors that were even more unique to this crisis:
• One, the financial system became over-leveraged and under-buffered in ways that were not transparent and were not all captured by the regulatory ratios. Because leverage was largely embedded in instruments, it was even greater than it was thought to be. Capital then became insufficient to buffer the drop in asset prices. And because incentive structures encouraged excessive risk taking, institutions and key markets relied increasingly on short-term wholesale funding and important maturity mismatches. And liquidity buffers were inadequate to deal with interbank disturbances.
• Two, the system became highly complex and opaque. Financial intermediation increasingly shifted to the “shadow banking” sector, partly to avoid regulatory requirements on banks. Lack of transparency and limited disclosure made it hard to assess exposures and potential spillovers, and magnified the shock to confidence and to faith in counterparties, as the crisis unfolded.
• Three, financial systems and markets became heavily inter-connected, domestically and globally, so that shocks were rapidly propagated across countries and across markets and the crisis had all the ingredients go very global very fast.
Much of what happened had to do with distorted or even perverse incentives. For owners and managers: too little capital and personal interests at risk and too much to gain. For regulators: inappropriate goals, too few tools, and too little incentives to act early enough. For the market: difficulties in exerting discipline given inadequate information and limited understanding of the risks embedded in complex financial instruments. Perverse incentives were most dangerous for the large, complex institutions that became “too-important-to-fail,” a status which let them borrow at preferential rates, operate with higher leverage, and engage in riskier activities.
We do not have time to discuss the reform agenda in detail, but let me stress the ultimate objectives. These are to ensure competitive financial systems that serve the needs of the real economy; are better-governed and more transparent; comprised of institutions endowed with higher, better quality, and globally-consistent capital base and liquidity buffers, which is subject to a regulatory and supervisory framework that appropriately weighs systemic risk and discourages procyclical lending; with a perimeter extended to include all important institutions, markets, and instruments, and which enables institutions— especially systemically important ones—to be resolved effectively, quickly, and with minimum cost to the taxpayer.
Obviously, these objectives mean a daunting set of reforms, in terms of depth, breadth, and global consistency. Much progress has already been made, including last weekend with the announcement bythe Group of Governors and Heads of Supervision on the parameters and timetables for minimum bank capital standards. The Fund welcomes this important step in achieving regulatory clarity. The new regulatory standards represent a significant improvement in the quality of capital in comparison with the pre-crisis situation. Robust capital and liquidity standards, intensive supervision, an effective resolution regime and sound macroeconomic policies are critical to attain financial stability. At the same time, impact assessment studies by the Basle Committee suggest that higher requirements and shorter phase-in periods would not impose undue pressures on the banking system and the real sector. As the global financial system stabilizes and the world economy gets back on a recovery track, one could consider further strengthening the requirements and shortening the transition period and thereby more effectively address some of the vulnerabilities that contributed to the recent crisis.
Together with the Financial Stability Board, the Basel Committee and other partners, the Fund is committed to further developing this agenda, contributing ideas and analysis. We will also undertake the many levels of follow-up and implementation needed: in our bilateral and multilateral surveillance; and in our analytical and data collection work.
One of the first questions of our topic today is: Where does taxation fit into this reform agenda? One of the lessons we quickly learnt in our work for the G-20 was that this question had previously received almost no attention, from either policy-makers or academics. So we had to go back to first principles. And that suggested three possible roles for tax reform.
The first, which we can surely all agree on, is that the tax system should at least do no harm or do the least harm. Yet what leaps out to mind here is the potentially massive incentive present in most tax systems to borrow rather than use equity finance that is implied by the deductibility against corporate tax of interest payments but not of the return to equity. This tax incentive to debt finance did not trigger the crisis. But we surely cannot ignore such a large pre-existing tax distortion acting precisely in the direction of excess leverage.
The question also arises as to whether the exemption of many financial services under the value added tax (VAT) creates a tax bias towards an overly-large financial sector. Some might add a concern that the mobility and complexity of financial institutions’ activities make them especially aggressive tax planners. Addressing these various distortions would require substantial changes to established tax practices. But there are encouraging experiences in countries that have tried to do so; and our report to the G-20 also proposed a new instrument, a Financial Activities Tax—the FAT—that might have a role in fixing some of the problems of the VAT.
A second role for special taxes on the financial sector is to pay for the fiscal cost of public intervention in its support. This is a matter of both fairness and efficiency. Fairness, because the equity case for large transfers to owners and managers of financial institutions is, shall we say, weak given that the expectation of such support is likely to lead to moral hazard with financial decision-makers ready to accept socially excessive levels of risk. It may be that, in the end, the final cost of direct fiscal interventions will be modest in many countries this time. But we cannot take too much comfort from that: many governments’ exposures at the height of the crisis were massive—maybe we just got lucky this time. Some would argue, moreover, that the financial sector should pay for some of the wider fiscal and social costs that are an indirect consequence of their failure—in the form of stimulus measures, for instance, and the even greater fiscal costs associated with the recessions.
It would be pleasant, of course, to suppose that financial failures and crises will never recur. But that would also be foolish: even under a perfectly reformed regulatory structure and a more engaged supervisory work, there will (and should be) financial failures in the future. Dealing with them requires, as I mentioned earlier, improved resolution regimes. And most of the time, as we have seen, resolution will require resources. And it is right that financial institutions meet any costs of these interventions, which are just one cost of doing business in a socially responsible way. Moreover, we believe they should provision for these costs before failures occur, and on a tax base that is related to the riskiness of their activities. That is the role of the Financial Stability Contribution that we proposed in our report to the G-20.
A third possible role is to change financial institutions’ behavior—a corrective or ‘Pigouvian’ motive. We should not forget the substantial evidence that a well-functioning financial system conveys strong external benefits on the wider economy. But the crisis has made all too apparent that the distress and failure of financial institutions also causes large negative externalities, adversely impacting other institutions and the wider real economy. In many areas of economic life, economists prefer to deal with externalities by tax or pricing measures rather than by direct regulation. Carbon pricing, for instance, is seen as a better way to address climate change than restricting emissions at firm level. And, in even more areas, we use both taxation and regulation—in dealing with smoking, for instance, we both impose heavy taxes and restrict where smoking is allowed. What then is the appropriate mix for the financial sector? While some measures—such as restrictions on activities—lend themselves most naturally to a regulatory approach, in other areas taxation is certainly an option. It could be used, for instance, to offset the benefit an institution seen as too big to fail gets from borrowing at low interest rates.
Taxes could discourage specific risky activities given the social consequences of failures. Some have suggested that, as an alternative to additional capital requirements for systemically important institutions, they should face a tax charge. Or excessive short-term funding could be discouraged through a price based tool, complementary to regulatory restrictions. And of course some argue for a role for generalized taxes on financial transactions, perhaps only on currency transactions, both as a way to address unproductive activities in the financial sector, and as a source of finance for development objectives. This was a concern beyond that mandated to us by the G-20 (for which we do not find transactions taxes to be well-suited) but remains an important part of the wider debate.
In all these areas, the relative merits of taxation and regulation need careful consideration. Taxation retains more flexibility for individual institutions. Regulation, on the other hand, is more certain in its effect, and may be easier to coordinate internationally, therefore limiting the scope for arbitrage and distortion. These are difficult intellectual and practical issues, and ones that, to my mind at least, remain less than fully resolved. I hope that today’s discussion can bring new light from experience and research to bear on them.
Let me touch, finally, on some reactions to our report for the G-20. Several countries, of course, have adopted or announced measures broadly similar to the Financial Stability Contribution that we proposed—although with differing degrees of linkage to improved resolution systems. Sweden, of course, had done so even before we had set to work; and France, Germany and the U.K. have indicated so in the last few months. Other countries were more opposed to new tax measures, especially those whose financial systems had weathered the storm relatively well. That response is understandable, but may be potentially short-sighted. No country should think itself immune from future financial failures and even crises. Even if you did better this time, it still pays to take measures to prevent or reduce the severity of future crisis. Moreover, charges along the lines of the financial stability contribution, if properly calibrated to the riskiness of institutions’ positions, would automatically be lower where regulation, supervision and financial institutions’ own behavior leads to less risk taking.
All this gives us plenty to talk about today. Of course, we won’t find all the answers. Indeed the right answer will differ across countries, according to their differing circumstances, experiences, and priorities. But that is why today’s event is so important. We have assembled speakers and participants whose depth and diversity of experience can, I have no doubt, will advance our understanding and appreciation of the scope for, and challenges of, tax reform in the promotion of financial stability. Taxation cannot, I would stress, be a substitute for regulatory measures of the kind I touched on earlier; but it can, I believe, be a valuable complement.
In closing, I would like to express, on behalf of the IMF, our particular gratitude to all today’s speakers for bringing us the benefit of their knowledge, experience and criticism. To all participants, indeed, I extend again both a welcome and our thanks for your presence. We have left plenty of time for discussion, and I look forward to a lively exchange. Let me also express, on behalf of us all, our thanks to Emmanuel van der Mensbrugghe and his team in the Fund’s Paris office, as well as staff of the Fiscal Affairs, Monetary and Capital Markets, and Research Departments in IMF headquarters, for all the hard work they have done to make today possible.
Thank you for your attention.
